Cap It, Tax It, What's The Difference? Well, A Few Things...

June 5, 2008

This week, a bunch of heavyweight econ-bloggers have been debating the merits of cap-and-trade versus carbon tax as means of curbing fossil-fuel usage. See here and here for round-ups; Brad DeLong in particular put some great topspin on his volleys. Most economists tend to prefer a carbon tax on the grounds that it's simpler and avoids the potential for the loopholes and unseemly handouts to polluters that have been associated with real-life cap-and-trade regimes such as Europe's.

I'm not totally sold on that latter objection—after all, K Street is perfectly capable of carving out all sorts of loopholes and exemptions to any sort of tax. And loopholes in a carbon-tax regime can, potentially, produce a lot more distortions than would giving away some permits under a cap-and-trade. (To take one example, even utilities that received permits for free still have to raise their carbon-powered electricity prices—due to the opportunity costs of not selling the permits—whereas polluters that won a carbon-tax exemption could just sit on their hands.) In the real world, as Daniel Hall suggests, a lobbyist-mangled cap-and-trade regime might actually end up being more efficient than a lobbyist-mangled carbon tax.

It's also true that a cap-and-trade system in which the government auctions off the vast majority of pollution permits—rather than handing them out for free—is structurally pretty similar to a carbon tax. There's just one main difference: With a tax, we know ahead of time what the price of carbon will be; we're just not sure how much a given tax rate will actually curb emissions. With a cap, we know what the emissions target is in advance; we just don't know how high the price of carbon will end up rising to meet that target. So with a tax, the main concern is setting the price too low to reduce emissions by the desired amount. With a cap, the biggest worry is setting too-strict targets that cause energy prices spike to economy-crippling levels.

Now, via Ryan Avent, Felix Salmon argues that this difference actually counts as a point in favor of a cap-and-trade regime:

Given the hysteria over energy prices in general and gasoline prices in particular, it's easy to imagine how a carbon tax would be set too low. And it's true that no one really knows what the elasticities are in the energy market, which means that an aggressively-low emissions cap could indeed send prices into the stratosphere.

But, realistically, what would happen in such an event? Would Congress sit idly by as fuel-oil costs exceeded monthly mortgage payments? Would they tell their constituents that, sorry, nothing they can do about $15-a-gallon gasoline prices, we set our cap and now we have to stick with it? Of course not. They would tweak the cap-and-trade system in one of any number of ways: they might allow companies to borrow emissions credits from future years, or they might implement a "safety valve" allowing the government to auction off new emission credits at a certain price, or they might simply raise the cap. Alternatively, of course, they could take the unexpected excess revenue from the cap-and-trade auctions and start mailing large checks to everybody in the country, thereby helping to cancel out the ill effects of higher energy prices.

I think that's basically true. I'll add a few other points: A carbon tax is a lot easier to administer—no small thing, given that the current EPA is pretty poorly equipped to oversee a task as complex as regulating CO2, at least without a large infusion of resources and staff. Another downside of a cap-and-trade regime is that it creates a vast carbon-trading lobby that's less interested in curtailing emissions than in preserving the lucrative carbon-trading market for its own sake. When that happens, traders like Goldman Sachs, for instance, start lobbying to ease restrictions on carbon-offset projects. A carbon tax, by contrast, probably wouldn't create brand-new interest groups that could end up working at cross-purposes with the larger environmental goals.